Bankers and trade association executives testify before the House Financial Services Committee during a hearing about the Volker Rule. (Chip Somodevilla/Getty Images)

The American Bankers Association said Wednesday that it would withdraw a legal request for emergency relief from a portion of the Volcker rule, a controversial regulation that bars banks from trading for their own benefit.

The trade group filed a lawsuit in late December to block a provision of the rule that would have forced community banks to shed a commonly held investment, but dialed back the fight after government regulators amended the provision Tuesday. The bankers association, however, said it will not drop the lawsuit until it completes a full analysis of the rule.

Late Tuesday, five regulatory agencies said banks with less than $15 billion in assets could retain collateralized debt obligations backed by trust-preferred securities (TruPS CDOs) — a financial instrument with hybrid characteristics of both debt and equity. The decision reversed a ban on banks owning such financial instruments.

Bankers were up in arms over the prohibition when regulators issued the final Volcker rule last month because the provision was not included in the original proposal. The bankers association argued that regulators violated the law by failing to give the industry notice. The group said the provision would force about 275 community banks to take a $600 million write-down on the value of the securities.

Indeed, Zions Bancorp, a regional bank based in Salt Lake City, said last month that it would have to take an after-tax charge of $387 million because of the provision. News of the write-down caught the attention of a bipartisan group of lawmakers on Capitol Hill who prodded regulators to ease the burden on small banks.

In response, federal regulators softened the restriction by allowing small banks to hold TruPS CDOs issued before May 19, 2010, and acquired before Dec. 10, which is when the Volcker rule was completed.

Frank Keating, president of the bankers association, applauded regulators for “revisiting the impact of the Volcker rule” and providing a “broad exemption for banks holding trust-preferred securities.”

In the lead-up to the financial crisis, banks issued trust preferred securities to raise money. Some of those securities were bundled into CDOs that were snapped up by community banks attracted to the steady interest payments and favorable tax treatment. But the securities plummeted in value during the crisis, making it difficult for banks to unload them without taking a huge loss.

“This investment was a casualty of the economic crisis, but never can it be considered an adventurous investment or one that presented a systemic risk,” Charlie Funk, chief executive of MidWest One, a $1.7 billion bank in Iowa City, said Wednesday during a House Financial Services Committee hearing on the Volcker rule.

Community bankers such as Funk have argued that the Volcker rule steamrolled small institutions in an effort to rein in risk-taking by Wall Street megabanks. Tuesday’s action signals that regulators will address unintended consequences of the rule, without conceding much ground to Wall Street, analysts said.

Regulators did not heed industry calls to extend the exemption to another security used by big banks, collateralized loan obligations. These bonds, comprised of leveraged loans made to companies, are sold to traders in the credit markets as a way to distribute the risk of default across many partners.

“Wall Street was hiding behind community banks on the TRuPS issue and were looking to bully regulators into creating a broad loophole to include CLOs,” said Dennis Kelleher, chief executive of Better Markets, which advocates for financial reform. “But what regulators sensibly did was to provide very narrow and specific relief.”

Without the exemption, analysts and industry groups say banks will need to unload upwards of $70 billion of CLOs by July 2015 to comply with Volcker.

“If this situation is not remediated, corporate borrowers could face higher credit costs and banks will suffer unnecessary losses,” Kenneth E. Bentsen Jr., chief executive of the Securities Industry and Financial Markets Association, warned in a statement.